Optimal Investment, Tobin's q, and Cash Flow: Does Unobserved Productivity Matter?

Abstract We study the classical relationship between a firm’s investment and Tobin’s q for which unobserved productivity is another factor of a firm’s decision. Besides the potential measurement problem of Tobin’s q, controlling unobserved productivity is a new challenge. We develop an econometric method that tackles both issues given timing and information set assumptions. Using 15,079 unique public firms in the U.S. for the period of 1975 to 2017, we find that cash flow remains a significant factor of investment even after controlling for the productivity and that investment becomes less sensitive to q and more sensitive to cash flow.